Euro zone bond yields tread water after Bank of Japan holds firm

Euro zone government bond yields stuggled for direction on Wednesday following a sharp drop on Tuesday, after the Bank of Japan stuck to its ultra-loose monetary policy. Germany's 10-year government bond yield, seen as the benchmark for the currency bloc, was up 1 basis point (bp) in early trading on Wednesday to 2.096%, having fallen earlier in the session.

Euro zone government bond yields stuggled for direction on Wednesday following a sharp drop on Tuesday, after the Bank of Japan stuck to its ultra-loose monetary policy.

Germany's 10-year government bond yield, seen as the benchmark for the currency bloc, was up 1 basis point (bp) in early trading on Wednesday to 2.096%, having fallen earlier in the session. Yields move inversely to prices. The 10-year yield dropped more than 10 bps on Tuesday after Bloomberg News reported that European Central Bank policymakers are increasingly considering a smaller, 25 bp interest rate hike at the March meeting. The report said a 50 bp increase in February remains likely.

The German benchmark yield is now far below the 11-year high of 2.569% touched at the start of the year, with falling energy prices soothing concerns about inflation and interest rate hikes. The focus of global markets on Wednesday was on the Bank of Japan, which overnight maintained its policy of yield curve control - through which it anchors the 10-year bond yield at around 0%. It also kept short-term interest rates at -0.1%.

"Today there's a little bit of a relief from the BOJ not acting," said Sphia Salim, head of European rates strategy at Bank of America. She added that global bond markets seemed to be treating it as a "non-event". Many investors expected the BOJ to ditch the policy after it jolted markets in December by suddenly widening the 10-year bond's trading band to 50 bps either side of 0%, a move widely read as a sign that further changes were coming.

Traders have been testing the BOJ's commitment to supporting the bond market, selling bonds heavily and pushing the 10-year yield above the 0.5% upper bound in recent days. BofA's Salim said European investors were mainly focused on the ECB.

"The story at the moment in Europe is all about the changes in guidance from ECB. So yesterday's story about the ECB maybe slowing the pace of hikes beyond February was quite a surprise." Germany's 2-year bond yield was last up 4 bps on Wednesday to 2.503%, having fallen earlier in the session and dropped 11 bps on Tuesday.

Meanwhile, Italy's 10-year yield was up 2 bps at 3.907%. That took the closely watched spread between Germany and Italy's 10-year yields to 180 bps, not far off the eight-month low of 176 bps hit on Jan. 13. Many analysts still expect the BOJ to further loosen monetary policy later in the year, potentially after current governor Haruhiko Kuroda steps down in the spring.

If the BOJ reduced its support for the bond market, yields would likely rise sharply. That could lure the country's investors back home and cause them to sell foreign bonds, strategists have said. Japan's 10-year yield had traded above 0.5% on Tuesday but fell sharply on Wednesday to 0.425%. The yen also tumbled, with the dollar up more than 1.3% against the currency.

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